Variance Risk Premium and Investment Uncertainty
50 Pages Posted: 13 Jul 2016
Date Written: July 1, 2016
This article documents that variance risk premium decreases investments by the firms. The premium increases the value of waiting to invest in the real-option framework; risky volatility adds to the hedge value of postponing non-recoverable project costs. Empirically, we also find a negative relation between the variance risk premium and the firms' investment. In particular, the relation is more important for investment-grade firms with low historical volatility and high volatility risk premium. In a preliminary analysis, we report a puzzling conservative investment behavior by the investment-grade firms, which only can be addressed by considering the premium.
Keywords: Real option, Variance risk premium, Optimal timing, Stochastic volatility
JEL Classification: D81, G13, G31
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